Attention Shifts Back to the Foreclosure Crisis

The recent financial crisis began at least in part as a housing crisis. The toxic assets that initially threatened to bring down the global financial system were largely based on subprime residential mortgages; as borrowers began defaulting on those mortgages, whole classes of complex securities began plummeting in value.

The other side of banks losing money on their risky investments, of course, is homeowners losing their houses through foreclosure. In the dark months of September to February, it was common to say that the financial crisis would not end until the foreclosure crisis ended. Recently, however, as major banks have reported death-defying profits, one hears that sentiment less often; perhaps the financial sector can recover even as the foreclosure wave continues to crash down on communities across the country.

Today the Joint Economic Committee held a hearing on the foreclosure crisis, featuring a new report by the Government Accountability Office. And the evidence shows that the foreclosure crisis is very much not over, even if it is fading from the front pages.

According to the GAO, of 14.4 million nonprime (subprime or Alt-A) mortgages originated from 2000 to 2007, 1.6 million have ended in foreclosure; of the 5.2 million that are still active (the remainder were paid off, either through sale or refinancing), 1.8 million are delinquent, in default or in the foreclosure process. In his testimony today by Keith Ernst of the Center for Responsible Lending, as the mortgage crisis spreads into prime mortgages, the total number of defaults could climb to 13 million.

Foreclosures matter for three reasons. First, being forced out of a house, and losing any equity in that house, is, at minimum, a major economic blow to a family. Second, foreclosures generate economic externalities: They lead to increased crime and depress property values, even for neighbors who are current on their mortgages. Third, foreclosures create economic losses for lenders because the foreclosure process itself destroys value, in turn hurting the value of those mortgage-backed securities and putting increased pressure on banks.

Throughout the crisis, the government has shown great interest in reason number three. The Treasury Department and the Federal Reserve have taken dramatic action whenever the financial system as a whole was in danger, ranging from guarantees of money-market funds and bank debt to the unprecedented bailouts of AIG, Citigroup and Bank of America. As a result, when Treasury Secretary Timothy Geithner introduced the administration’s Financial Stability Plan on Feb. 10, only three weeks after President Obama took office, foreclosure prevention was one of the main pillars of the plan.

Yet the centerpiece of that effort, Making Home Affordable, has been a disappointment. As The Post's Renae Merle reported earlier this month, the administration has acknowledged that loan servicers have made little progress in modifying loans at risk of default. Those modifications that have occurred are largely of the “extend and pretend” variety, whereby missed payments and fees are simply added to the balance owed. Only 1.8 percent, by contrast, included a reduction of principal.

Given the weak and deteriorating state of the job market, these “modifications,” while enabling loan servicers to pad their statistics, are highly likely to end in re-default. And as Merle reported today, this is simply because lenders often prefer foreclosure to modification.

The political question is whether, now that the large banks seem able to generate enough profits from trading and fees to offset their deteriorating loan portfolios, the administration will put additional effort into stemming the tide of foreclosures. Now that reason number three for reducing foreclosures no longer seems compelling, are numbers one and two enough to prompt action? Or will the administration decide that millions of foreclosures are acceptable so long as the financial system remains intact?

There are three kinds of losses when the lender/servicer actually takes possession of the property. First, there is a paper loss in asset value as the property is often sold for much less (average, I think, is 60%) than the mortgage. Second, the neighbors' homes lose value. Third, and equally important is that in many cases the home is physically damaged. The roof or plumbing may leak, etc., or drug addicts may enter and remove fixtures, plumbing, wiring, and anything that they can sell. This real destruction of value does not get the attention it deserves.